Housing: Option Value Or Too Much Risk

Includes: MAS, XHB
by: Robert Rubin

So far, 2012 has started off well. Stocks are up. Gold is up. Economic data have been within consensus. Our friends across the pond in Europe haven't defaulted on anything as of the moment. The emerging markets (an indicator of stock market vitality) are outperforming. And, very notably, the housing sector has emerged as a leader in the S&P 500 (NYSEARCA:SPY), with the SPDR S&P Homebulders ETF (NYSEARCA:XHB) leading sector ETFs, up 11.81% so far in 2012, continuing momentum from 2011. It is the rally in homebuilders that I think is worth some exploration. In particular, is buying into this rally a play on the bottom (for future upside option value) or is the bottom already priced in, with some real underlying risk baked into the prospective play?

Let us consider the following facts:

  • Housing starts figures for December 2011 were released Thursday morning, at 657k units, down from the 685k units in November. Forget for a minute the monthly drop. More relevant, these data have been published monthly since 1959, and only seven times since that period did starts get close to or below 1.0 mm starts. The average recovery off the 1.0 mm to above 1.5 mm starts, the average monthly number since 1959, happened swiftly, with an average recovery time of around 7 months. This time? Since breaking below 1.0 mm units in September 2008, we have seen 13 months and no recovery. At all. With starts dropping in December, and little momentum back to the 1.0 mm "bottom," it appears premature to conclude that a recovery has begun.
  • Ditto for building permits. With bottom in the 700k-800k permits context (hit five times since 1959), recovery back to the historical "average" of 1.391 mm permits has taken about 7 months. Right now, at 679k permits (still below the "bottom"), there hasn't been much improvement in 13 months. Similar to housing starts, concluding that we are in recovery seems premature.
  • The S&P/Case-Shiller Composite 20 Home Price Index has not begun to recover. Prices are still falling (although the velocity of downside has slowed materially). The Seasonally Adjusted figure just hit a multi-year low.
  • The Fed, in a recent white paper, has highlighted the need to support housing.

Despite the lack of recovery and the highlighted need for government intervention thanks to that lack of recovery, homebuilders (and the accompanying group of linked businesses) have rallied significantly to start the year (coming off the strong last few months of 2011). The principal argument for the recent rally as I understand it: Fed (and U.S. Government) intervention will lead housing starts up, building permits up and support an improvement in pricing, as Fed (and U.S. Government) intervention has proven to be successful so far in (1) averting a massive financial crisis in the banks, (2) helped restore the viability of the U.S. Automakers, (3) stimulated some growth, supported risk assets and expanded credit through outright manipulating the U.S. Treasury market (buying bonds, pushing down yields). With a recent track record of successful intervention (regardless of moral hazard, which is a different topic), it is easy to make the case that if the Fed (and U.S. Government) get more involved in housing, there is the potential for accelerated recovery.

So by investing now, are you buying option value (as in, a massively mispriced market to the downside?) I do not think so. Take a company like Masco, Inc. (NYSE:MAS), the lead holding in the XHB, that is up 19.8% in 2012 as of the time of this writing. MAS manufactures and sells home improvement and building products. Using consensus estimates, the stock is trading at 10.1x 2012 on an EV/EBITDA basis (with an assumed $705.3 mm of EBITDA in 2012, over the $576.0 mm of EBITDA in 2011). Against 2013, the stock is trading at 7.6x, against a forecast EBITDA of $937.3 mm. Through the housing cycle boom (2002-2007, with starts in excess of the 1.5 mm units average), MAS generated EBITDA of $1.4 - $1.9 billion annually. When starts were around average (late 1990s), MAS generated EBITDA in the $900 mm to $1.0 billion context. Considering the 2013 consensus estimate, it would appear that the market is pricing in some recovery to within the context of the average starts. That doesn't feel like an "option" on recovery. It feels like the market is pricing in a legit recovery over the next two years.

This analysis should be done for the homebuilders group broadly before making an investment. Buying into the Fed intervention thesis could prove costly if numbers don't improve, as valuations across the group could come down swiftly. The market is pricing in recovery, to some extent. It seems to me that if you missed this current rally, it might prove prudent to wait here, as speculation now feels more like a call on a recovery and less about an option on the recovery, which seems to have a mixed risk vs. reward prospectively.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.